In general, I tend not to go in for macro themes.  Why?  I tend to get them wrong, and I think most investors also get them wrong, or at least, don’t get them right consistently.

I do have one macro theme, and it has served me well for a long time, though not over the past two years.  I was using the theme as early as 2000, but finally articulated it in 2006.

At that time, I was running my equity strategy for my employer, as well as in my personal account.  They used it for their profit sharing plan and endowment.  They liked it because it was different from what the firm did to make money, which was mostly off of financial companies, both public and private.  They didn’t want employees to worry that their accrued profit sharing bonuses would be in jeopardy if the firm’s ordinary businesses got into trouble.  In general, a good idea.

At the end of the year, I needed to give a presentation to all of the employees on how I had been managing their money.  Because my strategies had been working well, it would be an easy presentation to make… but as I looked at the prior year presentation, I felt that I needed to say more.  It was at that moment that the macro theme that i had been working with became clear to me, and I called it: Our Growing World.

The idea is this: in a post-Cold War world where most economies have accepted the basic idea of Capitalism to varying degrees, there should be growth, and that growth should create a growing middle class globally.  This middle class would be less well-off than what we presently see in America and Western Europe, at least not initially, but would manifest itself in a lot of demand for food, energy, and a variety of commodities and machinery as the middle class grew.

Now, I never committed everything to this theme, ever.  Maybe one-third of the portfolio was influenced by it, on averaged.  Most of what I do was and still is more influenced by my industry models, and by bottom-up stock-picking.

That said, the theme has a cyclical bias, and cyclicals have been kicked lately.  I still think the theme is valid, but will have to wait for overinvestment and overproduction in certain industries to get rationalized globally.  Were this only a US problem, it might be easier to deal with because we’re far more willing to let things fail, and let the bankruptcy process sort these matters out.  Governments in the rest of the world tend to interfere more, particularly if it is to protect a company that is a “national champion.”

But the rationalization will take place, and so until then in cyclical industries I try to own financially strong companies that are cheap.  They will survive until the cycle turns, and make good money after that.  That said, the billion dollar question remains — when will the cycle turn?

More next time, when I write about my industry model.

As I was reading today, I ran across a quotation from Stanley Fischer, Vice-Chairman of the Federal Reserve.  It was from an interview on CNBC in April 2015.  I went to get the original source, and here it is:

Still, Fischer emphasized that a tightening would be slight.

“We have to ask what will go wrong,” he said. “I say that if we get this in proportion, we’re going to be changing monetary policy from the most extremely expansionary we’ve been able to do in all of history, to an extremely expansionary monetary policy.”

Fischer added that the expected increase of a quarter of a percent would be the lowest rates had ever been if not for the recent move to zero.

This is the same mistake that Ben Bernanke made when he talked about the “taper” back in 2013, and the same error that Janet Yellen is making now. At any given point in time, there is a schedule of interest rates going out into the future that reflects the future path of rates that the Fed controls.  This isn’t perfect because almost none of us can borrow at those rates, but if credit spreads don’t vary much, movements in the schedule of rates, driven by expectations of monetary policy, affect business actions.

This implies two things:

  1. Direction matters more than position in monetary policy.  If expectations have moved from “zero for a long time” to “over 1% by the end of next year,” that is a large shift in expectations, and should slow business down as a result.
  2. As a result, you can look at the Treasury curve as a proxy for the effectiveness of monetary policy.

On that second point, I have collected the Treasury yield curves since the middle of 2015 on the days after monetary policy announcements.  Here they are, so far:





You can see the impact of the FOMC tightening out to five years, maybe seven.  After that, there is no effect, so far, except to say that the yield curve is already flattening, and that the Fed my end up stopping much sooner than many expect — including the FOMC and their “dot plot” which expects a 2%+ Fed funds rate in 2017, and 3%+ in 2018.  Unless the long end of the yield curve reprices up in yield, there is no way those higher Fed funds rates will happen.

Which brings me back to Stanley Fischer.  He’s a smart guy, perhaps the smartest on the Fed Board.  Maybe he meant there was no way rates could rise much for a long time.  If that’s the case, he may be way ahead of the curve.  Only time will tell.


If you always overestimate, and don't change, what does that imply?

If you always overestimate, and don’t change, what does that imply?

Since the FOMC started providing their estimates on economic aggregates four years ago, I’ve been simplifying them, and posted a weighted average to cut through the clutter of their releases.  From the above graph, you can see one thing that is consistent:  They overestimate GDP.  Far from seeing GDP over 3%, GDP has come in squarely in the 2% range.

It may even be that this is slowly wearing on the participants, who have progressively lowered their initial estimates of future GDP over time.  You can see that in the initial estimates of GDP 2014-2018, and also the decline in long-term GDP moving from 2.5% to 2.0% in four short years.

The FOMC is no different than the rest of us — they are subject to groupthink and playing catch-up.


You can give them a little more credit on unemployment.  At least things are going the way they would like.  That said, improvement in the unemployment rate has exceeded their estimates, while GDP has fallen under their estimates.

They live in a bubble, so please don’t tell them that labor measures don’t correlate so tightly with the economy as a whole.  I mean, in the long run, the correlation is high and significant, but as far as short-term policy goes, the relationship has a lot of noise, particularly amid globalization and improvements in technology.


Same applies to the PCE inflation rate… they think they can get inflation going (whether truly desirable or not).  So where is it?  Federal Reserve, you say you have the vaunted powers to create and destroy inflation.  If you can do something, do it.

My guess is that the Fed won’t do it.  As with most central banks, they have engaged in a game where they increase some aspects of internal credit, and in a way where precious little if any leaks out to the unfavored wretches with no access.

On the short-term bright side, they absorb government debt, which makes it easier for the US Government to keep our taxes low.  On the dim side, central banks buying lots of government debt has tended to backfire in the past.


Finally, the FOMC participants have overestimated for the last four years the need and willingness to tighten monetary policy.

Can we agree that QE really didn’t do that much, and that the unemployment rate pretty much solved itself, aside from losing a lot workers permanently?  These graphs behave the way a bunch of “true believers” would think their great power should  work, and them slowly give in to reality annually, but not permanently.

Anyway, consider these articles post-Fed tightening:

Fed Ends Zero-Rate Era; Signals 4 Quarter-Point Increases in 2016 Bloomberg)

This article is too excited, the math of the FOMC indicates more like 3 quarter-point moves.  Also note that the FOMC is not very permanent about their views, plans, or whatever.

The Fed and Wall Street Differ on How High Rates Will Go (Bloomberg)

Wall Street, correctly looking at the past says that the Fed has moved slower than they said they would.  Why should it be any different now?

Fed Raised Rates Without a Hitch, and It Only Took $105 Billion (Bloomberg)

Too triumphalist about the first tightening.  Wait for the cost of funds to catch up at the banks.

Fed Hikes, but Some Rates Veer Lower (WSJ) Subtitle: Yields on Treasurys drop after central-bank move

That’s part of what I would tell you to watch — if the yield curve flattens quickly, the FOMC will not do so much, most likely.  They will still keep going till something blows up.

One final note, and one that I don’t have a link for… Moody’s suggested in a macroeconomic note that yield spreads on junk debt are too high for the FOMC to tighten much.  Nice thought, though we are in an unusual situation for both Fed funds and junk debt.  That rule may not apply.

Photo Credit: Day Donaldson

Photo Credit: Day Donaldson

October 2015December 2015Comments
Information received since the Federal Open Market Committee met in September suggests that economic activity has been expanding at a moderate pace.Information received since the Federal Open Market Committee met in October suggests that economic activity has been expanding at a moderate pace.No change.
Household spending and business fixed investment have been increasing at solid rates in recent months, and the housing sector has improved further; however, net exports have been soft.Household spending and business fixed investment have been increasing at solid rates in recent months, and the housing sector has improved further; however, net exports have been soft.No change.
The pace of job gains slowed and the unemployment rate held steady. Nonetheless, labor market indicators, on balance, show that underutilization of labor resources has diminished since early this year.A range of recent labor market indicators, including ongoing job gains and declining unemployment, shows further improvement and confirms that underutilization of labor resources has diminished appreciably since early this year.Shades labor employment up.
Inflation has continued to run below the Committee’s longer-run objective, partly reflecting declines in energy prices and in prices of non-energy imports.Inflation has continued to run below the Committee’s 2 percent longer-run objective, partly reflecting declines in energy prices and in prices of non-energy imports.No real change.
Market-based measures of inflation compensation moved slightly lower; survey-based measures of longer-term inflation expectations have remained stable.Market-based measures of inflation compensation remain low; some survey-based measures of longer-term inflation expectations have edged down.Little change and mixed.  TIPS are showing lower inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 1.71%, down 0.08% from September.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.No change. Any time they mention the “statutory mandate,” it is to excuse bad policy.
The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate.The Committee currently expects that, with gradual adjustments in the stance of monetary policy, economic activity will continue to expand at a moderate pace and labor market indicators will continue to strengthen.Shifts language to reflect moving from easing to tightening.
The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced but is monitoring global economic and financial developments.Overall, taking into account domestic and international developments, the Committee sees the risks to the outlook for both economic activity and the labor market as balanced.Flips the sentence around with little change in meaning.
Inflation is anticipated to remain near its recent low level in the near term but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of declines in energy and import prices dissipate. The Committee continues to monitor inflation developments closely.Inflation is expected to rise to 2 percent over the medium term as the transitory effects of declines in energy and import prices dissipate and the labor market strengthens further. The Committee continues to monitor inflation developments closely.CPI is at +0.4% now, yoy.  Not much change in the meaning.
The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen some further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.The Committee judges that there has been considerable improvement in labor market conditions this year, and it is reasonably confident that inflation will rise, over the medium term, to its 2 percent objective.Sentence moved from below.  I reordered the last FOMC Statement to reflect the change.

Language changes to reflect the move to tightening.

To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate.Given the economic outlook, and recognizing the time it takes for policy actions to affect future economic outcomes, the Committee decided to raise the target range for the federal funds rate to 1/4 to 1/2 percent.Language changes to reflect the move to tightening.
In determining whether it will be appropriate to raise the target range at its next meeting, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. The stance of monetary policy remains accommodative after this increase, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation.Language changes to reflect the move to tightening.
 In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation.New sentence.  Gives expected measures for analysis of policy.
This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.No change.  Gives the FOMC flexibility in decision-making, because they really don’t know what matters, and whether they can truly do anything with monetary policy.
 In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.New sentence.  Says that they will go slowly, and react to new data.  Big surprises, those.
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.Says it will keep reinvesting maturing proceeds of agency debt and MBS, which blunts any tightening.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run. Sentence no longer needed.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams.Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Jeffrey M. Lacker; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams.All agree on tightening, but do they agree on why?
Voting against the action was Jeffrey M. Lacker, who preferred to raise the target range for the federal funds rate by 25 basis points at this meeting. Lacker got what he wanted.


  • They finally tightened. The next two questions are how much and how quickly.  The last question is what they do when something blows up.
  • The only data change for the FOMC is that labor indicators are stronger. I still don’t see it, aside from the unemployment rate.  Too many people dropped out of the labor force.
  • Equities steady and bonds rise. Commodity prices rise and the dollar falls.  Maybe some expected a bigger move.
  • The FOMC says that any future change to policy is contingent on almost everything.
  • Don’t know they keep an optimistic view of GDP growth, especially amid falling monetary velocity.
  • The key variables on Fed Policy are capacity utilization, labor market indicators, inflation trends, and inflation expectations. As a result, the FOMC ain’t moving rates up, absent improvement in labor market indicators, much higher inflation, or a US Dollar crisis.

Photo Credit: Jason Wesley Upton || Of course this isn't China...

Photo Credit: Jason Wesley Upton || Of course this isn’t China…

I know this is redacted, but it is advice to a reader in a really remote area of the world.  You might find it interesting.

I am currently with the XXX team in XXX.  We are taking about trying to budget the [project] with the inflation of the past months being 50%. And September being 91%. I think XXX would appreciate your thoughts on the likely economic and inflation situation. They are trying to decide whether to move to working on dollars. And how to budget if they stay in the [local currency].

Dear [Friend],

One question that may not matter so much… is the inflation rate 50-91%/year, or 50-91%/month?  The reason I ask this is if that is the rate per month, then you should try to do as much business as you can in dollars, and/or treat the local currency like a hot potato… don’t hold onto it long – it is not a store of value.  It is normal in such a situation for another currency to become the practical currency when inflation gets that high… even if it is illegal.

If the rate is 50-91%/year, that’s not great to work with, but prices are still moving slow enough for you to have some degree of a planning horizon in the local currency.  Still, any big transactions should be done in dollars, unless you are certain that you are getting a favorable rate in the local currency.

As for budgeting, it could be useful to do the budget in both currencies.  This will help to raise the natural question of what happens if you don’t have the right currency.  Here’s what I mean: ask what currencies you would naturally use to transact to accomplish your goals – look at both revenues and expenses.  If you find your expenses are mainly in dollars or euros, but revenues are in the local currency, you will need to do one of two things.  Either a) try to charge in hard currency terms, or raise revenue rates regularly, or b) build in a significant pad in local currency terms for the things you would typically buy in a hard currency.

Feel free to send me a spreadsheet on this.  As an aside, you can tell XXX that I have little trust that the situation will improve rapidly.  The government is too corrupt, its budget way out of balance, and any revenue from oil is down.  It would take a hero willing to end the corruption, and then survive ending it, in order for the inflation to stop.

In closing, the following paragraph is illustrative, and not strictly relevant:

I realize that you all aren’t investing in the country, but if you were, I would give the following advice: invest in land.  In a nation where there are no securities market, and the government is the cause of the inflation, land is the only thing that retains value.  AIG used to do this all the time in countries, particularly when they couldn’t remit their earnings there back to the US.  As they say in Argentina, “The wealthy preserve their wealth by owning land.”  So long as land is not expropriated, it protects wealth against governments who steal via inflation.  Gold is similar, but where you are, something that light and valuable could easily be stolen.

Anyway, I missed you at XXX, and hope and pray that you are doing well.  If you or anyone else on the team has questions on this, just let me know.  I’ll make time for you.

In Christ,


A while ago I wrote two pieces called “Easy In, Hard Out.”  The main idea was to illustrate the difficulties that the Federal Reserve will face in removing policy accommodation.   In the past, the greater the easing cycle, the harder the tightening cycle.  I don’t think this time will be any different.

In the last two pieces, I showed three graphs to illustrate how the Fed’s balance sheet has changed.  I’m going to show them again now, updated to 11/11/2015.  Here’s the graph showing the liabilities of the Federal Reserve — i.e. what the Fed eventually has to pay back, occasionally with interest:

I’ve added a new category since last time — reverse repurchase agreements (“reverse repos”) because it has gotten big.  In that category, you have money market funds (etc.) lending to the Fed to pick up a pittance in interest.

As you might note — as the balance sheet has grown, all categories of liabilities have grown.  The pristine balance sheet composed mostly of currency is no more — it is only around 30% of the liabilities now.  The biggest increase in reserve balances at the Fed — banks lending to the Fed to receive a pittance in interest, because they have nothing better to do for now.

I’ve considered doing an experiment, and I might do it over the next few weeks.  I went to my copy of AAII Stock Investor, and pulled out the contact data for 336 banks with market capitalizations of over $100 million.  I was thinking of calling 10 of them at random, and asking the following questions:

  • What has the Fed’s ZIRP policy done to your business?
  • Do you have a lot of money on deposit at the Federal Reserve?
  • When the Fed raises the short-term interest rate, what do you plan on doing?
  • Then, the same questions asking them about their competitors.
  • Finally, who has the most to lose in this situation?

It could be revealing, or it could be a zonk.

One more interesting note: reverse repos and my “all other” category have become increasingly volatile of late.

Here’s my next graph, with the asset class composition of the Fed’s balance sheet:

The Fed has gone from a pristine balance sheet of 95% Treasuries to one of 60/40 Treasuries and Mortgage-backed securities [MBS].  MBS are considerably less liquid than Treasuries, particularly when you are the largest holder of them by a wide margin — I’ve heard that it is 25% of the market.  The moment that it would become public knowledge that you were a seller, the market would re-rate down in price considerably, until holders became compensated for the risk of more MBS supply.

Finally, here is the maturity graph for the assets owned by the Fed:

The pristine balance sheet of 2008 was very short in its interest rate sensitivity for its assets — maybe 3 years average at most.  Now maybe the average maturity is 12?  I think it is longer…

Does anybody remember when I wrote a series of very unpopular pieces back in 2008 defending mark-to-market accounting?  Those made me very unpopular inside Finacorp, the now-defunct firm I worked for back then.

I see three hands raised.  My, how time flies.  For the three of you, do you remember what the toxic balance sheet combination is?  The one lady is raising her hand.  The lady has it right — Illiquid assets and liquid liabilities!

In a minor way, that is the Fed now.  Their liabilities will reprice little as they raise rates, while the market value of their assets will fall harder if the yield curve moves in a parallel shift.  No guarantee of a parallel shift, though — and I think the long end may not budge, as in 2004-7.  Either way though, the income of the Fed will decline rapidly, and any adjustment to their balance sheet will prove difficult to achieve.

What’s that, you say?  The Fed doesn’t mark its assets to market?  You got it.  But cash flows don’t change as a result of accounting.

Now, there is one bit of complexity here that was rumored at the Cato Conference — supposedly the Fed doesn’t use a prepayment model with its MBS.  If anyone has better info on that, let me know.  If true, the average life figures which are mostly in the 10-30 years bucket are highly suspect.

As a result of the no-mark-to-market accounting, the Fed won’t show deterioration of its balance sheet in any conventional way.  But you could see seigniorage — the excess interest paid to the US Treasury go negative, and the dividend to its owner banks suspended/delayed for a time if rates rose enough.  Asking the banks to buy more stock in the Federal Reserve would also be a possibility if things got bad enough — i.e., where the future cash flows from the assets could never pay all of the liabilities.  (Yes, they could print money together with the Treasury, but that has issues of its own.  Everything the Fed has done with credit so far has been sterile.  No helicopter drop of money yet.)

Of course, if interest rates rose that much, the US Treasury’s future deficits would balloon, and there would be a lot of political pressure to keep interest rates low if possible.  Remember, central banks are political creatures, much as their independence is advertised.


Ugh.  The conclusions of my last two pieces were nuanced.  This one is not.  My main point is this: even with the great powers that a central bank has, the next tightening cycle has ample reason for large negative surprises, leading to a premature end of the tightening cycle, and more muddling thereafter, or possibly, some scenario that the Treasury and Fed can’t control.

Be ready, and take some risk off the table.

Blogging a whole conference can be an exhausting affair.  Two things I did not expect — sitting in on the press conference with Lacker and Bullard, and blogging the Lunch speaker from the BIS [Bank of International Settlements].

There were a lot of themes that went around.  I’ll try to highlight a few of them, and add my own thoughts.

What is the proper mandate for the Central Bank?

The representatives from the Fed generally thought the dual mandate worked well.  Most of the critics favored a single mandate of preserving purchasing power of currency, and no mandate of full employment.  The reasoning varied there, but as Plosser commented, a dual mandate is what gives the Fed wiggle room to not be rules based, but discretionary.  Others commented that the ability of the Fed to affect labor issues is poor.

Plosser also told us to consider the actual text of the dual mandate:

“The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.”

He said it was interesting how it focused on monetary and credit aggregates as the tools to affect employment, prices, and long interest rates.  I had to admit when I heard that, that the dual mandate is better and worse than I thought.  Better because it focuses on money and credit as a unit.  Worse, because it gives the Fed three disparate targets, and the Fed is bad enough in trying to hit stable prices.  It doesn’t need distractions.

Beyond that, most agreed that adding even more targets for monetary policy was a really bad idea — effects on foreign countries, level of the currency, etc.

That said, Borio of the BIS suggested that monetary policy might be better off with a single mandate focusing on growth of liabilities to avoid financial crises, because financial crises cut economic growth severely.  This is closer to the way that I think.  The Fed should adopt a goal of modesty, and merely try to avoid messing things up, as they did with the flood of liquidity prior to the Great Depression, and in 2003-7.

Aiming for a moderate growth in total liabilities would probably be a better version of Friedman’s idea of a constant growth in M2.

Rules vs Discretion

This one was more agreed.  Most favored a more rules-based monetary policy.  As noted above, the main argument was over what the rule should be.

Central Bank Independence

There are two questions on Central Bank independence.  The first is what are they independent from, and the second is whether they are competent.  Over both of those is a question of accountability.  Ultimately, they are a creature of Congress, and should be directly accountable to Congress.

As I have pointed out before, the Fed protests actions that compromise their independence, while taking actions to serve the political ends of those they favor.  Put more simply, the Federal Reserve, like many nonprofits, is managed for the good of the management of the Federal Reserve.  They do that which maximizes their power and resources, subject to risk constraints.  This isn’t too surprising — most bureaucracies behave that way.

Are things normal or broken?  Did the Fed rescue us, or create a bigger crisis to come?

The Fed governors and a few economists felt that things are mostly normal, while most of the rest felt that things are broken, and a greater crisis could come.

What crises could we face?  There are the simple ones, like sending the emerging markets through the shredder.  Many noted at the conference how the monetary policy of the big nations travels to the smaller nations under a system of floating exchange rates.

Another possibility is with residential mortgage bonds limited to a few coupons — negative convexity is potentially high.  Tightening, if it led to a rise in long rates, could be like 1994, one of the worst years the bond market faced.

More likely is that deflation continues, and the Fed reinforces it with more QE.  All of the Fed’s forecasts have erred on the side of rapid growth that has not materialized.  As it is, with demand growth limited, we continue to bump along the bottom with ZIRP, with the Fed’s balance sheet growing bit by bit.

What will happen when Fed tightens?

Maybe not much.  Maybe too much.  It will be interesting to see how how banks and money market funds react to slightly higher rates.  I lean toward the “maybe not much” if/when they tighten.  I’m still not convinced that the Fed will tighten, simply because they have let a lot of little mini-crises derail them from what could be a more important task — that of normalizing the yield curve.  What will go “boo” next week?

Four Final Notes

  1. The Fed should not do fiscal policy, or quasi-fiscal policy.  The Fed is less effective at its main task of monetary policy because they go after areas outside the core of what they have to do: buying MBS rather than Treasuries only, buying long Treasuries rather than short Treasuries, and being a financial & systemic risk regulator.  A monetary policy that is not aggressive will avoid systemic risk… but the Fed went too far many times in easing policy, and not far enough in tightening policy when it was needed.
  2. The session on the “knowledge problem” was interesting and right, but it is basically the problem that any bureaucrat runs into.  So long as you have regulation, the knowledge problem will exist.  That said, you didn’t need to have this session at a monetary policy conference, because the problem is not unique to monetary policy.
  3. Hilsenrath took up an argument of mine about the Fed — it is an intellectual monoculture of neoclassical economists.  Lacker argued that neoclassical economists often disagree with each other, so it’s not a problem.  It *is* a problem, though, because the methods don’t lead to good forecasts, and thus good policy.
  4. I think the Fed needs to revisit their models, and think more broadly — labor use is getting affected by demographics, technology and global trade.  These factors aren’t going away, and they are resulting in a permanent reduction in opportunities for the lesser-skilled areas of the workforces in the developed world, until the whole capitalist world is developed, and wage rates finish equalizing globally.

What should the Fed expect?  Its ideas are flawed at their core as the world has changed, and closed-economy macroeconomics don’t apply well.  Their efforts to change tinker at the edges, and don’t realize their tools aren’t effective.  Better to set modest goals for monetary policy of a stable price level with no debt bubbles.  That is achievable, and it is better to do what you can do well, than attempt things beyond your ability.

Photo Credit: DonkeyHotey

Photo Credit: DonkeyHotey

Rep. Bill Huizenga
Chairman, House Subcommittee on Monetary Policy and Trade

Suggested FSOC is a tool of the Fed to press fiscal agenda.  60 new regulations, thousands of pages.

High degree of discretion… Fed makes it up as it goes, like Jazz.

Government knows best is not  what is best for the economy as a whole.

The dual mandate allows the Fed to do things that go outside of what would be a strict monetary mandate — and what it can ultimately affect.

His bill HR 3189 will likely pass the House in the next few weeks, and then will head over to the Senate (where who knows will happen to it).

Aims to increase transparency and accountability of the Fed, and give more weight to the regional presidents.  How large the audits would be is open.  Emergency lending powers would be reduced.  Five of seven governors and nine of twelve regional Fed Presidents would have to approve any emergency lending.

Fed would have to take a rules based strategy for monetary policy.


1) David Malpass: Would the bill change IOER?


2) Any audit of the IOER?

Not at present.

3) — goes into article 1.10 of the Constitution to have the states insist on commodity money — gold and silver?

How do we get back to a gold standard?  How could we educate the public on its value?  Would back money with a basket of commodities.

4) Torres of Bloomberg: what if the Fed buys more assets in another recession years from now?

Would lead to frustration.  The Fed should not be in that business.  Thinks many politicians are hypocritical because they tell the Fed what to do, and yet he gets accused of meddling with central bank independence.

5) Moderator notes that Elizabeth Warren wants to limit emergency lending — any chance for bipartisanship?

Quite possible, but banks will oppose it.

6) Alex Pollock: Sen. Shelby’s bill — how do you see his bill?

He doesn’t know enough to say, but he wants to get his bill through the House.

7) wouldn’t the Fed getting heavier regulation crash the equity markets?

This isn’t a question of that, everyone should have the same information and access to credit.

8) Can we keep Alexander Hamilton on the $10?

There are efforts to do that….

9) Buchanan suggested a monetary rule that would be in the Constitution?

They aren’t prescribing a rule.  Only holding them to a rule that the Fed itself would specify.

10) What of the Senate Bill, and how will you work with it?

Speaker Ryan is handling the House well.  We would like to do this on a bipartisan basis.

11) What to do with all of the reserves held at the Fed? Seiniorage?

Happy to take money away from Congress.

Photo Credit: European Parliament

Photo Credit: European Parliament


Moderator: Craig Torres
Reporter, Bloomberg

Jerry L. Jordan
Former President, Federal Reserve Bank of Cleveland

Lawrence H. White
Professor of Economics, George Mason University

Kevin Dowd
Professor of Finance and Economics, Durham University

Torres introduces White, who talks about the need for a Fed exit from credit policy

QE was not a monetary policy.  M2 anemic amid a huge rise in the monetary base.  High powered money ain’t.  Did not want to see M2 rise, which would lead to inflation.

Fed sterilized through interest on excess reserves [IOER].  This favored housing over other uses of credit.  Fiscal policy masquerading as monetary policy.

Dramatic impact on its portfolio duration and income.  Record interest income.  Most gets gets rebated to the Treasury, rest to the banks.  Thinks Fed’s average maturity has moved from 4 to 12 years.  Buiter predicted it.  Fed is doing it all for the Treasury.

Fed shouldn’t allocate credit.  Takes away Congress’s job of wasting money. [DM: he said it, not me]  Now a demand comes for a Puerto Rico bailout.  Can’t give away money costlessly, even if you print it.

Lowers penalty for failure.  At present the Fed has no plans to exit credit allocation; Congress will have to act to end it.

Jerry Jordan: Fed built the financial bubble.  13th Fed res bank?  Think he’s talking about Fannie and Freddie…

Monetary authorities as eunuchs.  Political Viagra needed.  Has fiat money run its course?

Foreign banks borrowing from the FHLB.

Money multipliers broken, high powered money does not exist.  Central bank balance sheet is unrelated to money conditions in the economy.  QE can be contractionary.  There is no possible exit from QE.  Stopping QE was good, but ending it will not happen, because IOER and reverse repos are the rule.  IOER borrows from banks and RR borrows from money market funds and GSEs.

Zero experience on IOER and Rev repos.  Who knows what would happen if inflation rose?

Conclusion: aggressive Fed policy has had no impact on inflation, and the Fed does not truly affect credit at present.  Thee are no tools now for dealing with a rise in inflation.

Torres: things are anything but normal now.

Dowd: Extreme Keynesian Policies have not delivered.

Hi recommendation: Recommoditize the dollar, recapitalize the bank, restore strong governance to banking, and roll back government intervention

?? Put Hetty Green on the $10 bill!

Commodity standards with a feedback rule. [DM: quack, quack]

Banks need to run with high levels of capital in order to take more risks.  Higher standards, and less gameable.  Riskier positions would be penalized.

Banks would not be able to pay bonuses, dividends, buy back stock until they were compliant.  SIFI banks only at 7% GAAP capital, 5% under IFRS.  Social consequences of higher bank capital levels are zero.  Capital is not a “rainy day fund.” [True]

Bank directors would be limited to unlimited personal liabilities.  Bring back double liability for shareholders?  Unlimited liabiity for shareholders.  Look at the investment banks; when they went public, they threw risk control away.

GSEs and Fed  would be wound down.  Oligarchy of bankers block reform.  Take the crony out of capitalism.


1) High capital requirements but deregulating — what are you proposing? Depositors will seek highest return, and create another type of moral hazard.

D: Aims for getting the government out of the economy.

2) Bert Ely: possibility for capital arbitrage?  Also shadow banking?

D: Capital rules created capital arbitrage.

Another fellow suggested that banks would be entirely equity funded.

3) Question on abolishing cash?

D: Deflationary collapse.

4) What would happen if people were taxed for holding cash?

Much held by foreigners — punish them with negative interest rates.  But it will never happen.

5) To Larry: what of negative interest rates.  Wouldn’t assets still stay at the Fed for regulatory reasons?

W: ??

6) Transition from monetary to fiscal policy at the Fed?

Bernanke’s theory was that housing had to be preserved above all else.  Same thing for long term rates.  Debt service costs to Treasuries reduced.

7) Wouldn’t negative interest rates destroy GDP?

Yes. then asked about whether there were any bond investors.  Asked what would happen if the Fed tried to sell its mortgages.

Answer from one manager: I wouldn’t want to be the first buyer, and I wouldn’t trust the actions of the Fed… so the market and prices would back up considerably.


Photo Credit: Zach Copley


Moderator: George Melloan
Former Deputy Editor, Wall Street Journal

Gerald P. O’Driscoll Jr.
Senior Fellow, Cato Institute

Alex J. Pollock
Resident Fellow, American Enterprise Institute

David Malpass
President, Encima Global LLC

Melloan introduces Gerald P. O’Driscoll Jr.

The Knowledge Problem — Hayek argued that knowledge is dispersed — impossible to aggregate it without incentives.  What everyone knows is more than what regulators know.  There is no way that a central planner (or banker) could know what the right answer is for economics.  As such, socialism morphed to become social democracy.  USSR collapsed.

Rules encapsulate important knowledge gained by society over time, which enables actors to have a better idea of what to do.  Disclosure reduces fraud.

Monetary policy discretion gives too much power to a small group of men.

Pollock says that the Fed does not know what it is doing, and can’t know what it is doing.  The problem is too complex, and the knowledge to get and interpret to too hard.  Fed biggest SIFI of all, and creates more systemic risk than anyone.  The Fed as a result has not done well in the past, and is unlikely to do so in the future.

Financial instability was not destroyed by the Fed; experts are often given to aggressive actions from bad theories.  Faith in experts is a secular religious problem.

Prices quintupling in a lifetime is considered price stability.

“The Fed must be independent.” But if the Fed is not competent, then should it be independent?  How and to whom should the Fed be accountable.  No part of a democratic government should be unaccountable.  The Fed must be responsible to Congress.  That said, the Fed has often been a useful lapdog to the Congress… funding deficits, etc.  Congress in 1963 agreed with this idea at the 50th anniversary of the Fed.

Humphrey Hawkins does not help accountability.  Financial Accountability Improvement Bill — FOMC would have to make detailed reports to the Congress, including dissenting opinions.

Banking committees in both houses captured by the housing industry.

Calls for a joint committee on the Federal Reserve; should also be able to audit the Fed in any way appropriate.

“The money question” affects so many things that it needs to be broadly discussed.

David Malpass — Post-monetarism: the Fed’s Growth Options

Negative effects of Fed policy on the economy.  Fed is huge and distortive.

ECB — buy anything at any time.

ZIRP will weigh on growth for decades.

Post-monetarism — direct regulation of the financial system.  Monetary and credit policies merged.  Credit growth is slower as a result.  Required bank reserves have fallen and are rising now.  No transmission of M0 into other aggregates.  Fed buys long bonds and advantages them — benefits government and corporations.

Core capex orders are weak.  Employment to population ratio at a low, forget the unemployment rate.  Median household income is declining — increased inequality.

Fed has four options to boost growth:

a) move rates above the zero bound.  Aids savers and would be a loosening of credit.  Maybe the interbank laon market would increase.

b) taper reinvestment, and free up Treasuries for liquidity and collateral.  Fed assets at $4.5T.  Banks assets currently at Fed.

c) Increase repo borrowing.  Fed Liabs at $4.4T.  More credit gets pushed out to banks.  Would be more idle cash to lend.

d) Fed has a severe bunching of maturing assets in the short run.  Presently would invest maturing assets long.  Should the Fed own long duration assets?

Q&A — 1) no one has the interests of everyone else at heart.  Central bankers have poor incentives — they maximize for themselves

O’D: even with good motives, they can’t get it right

M: Quis Custodes Custodiet.

2) Freedom: gold can’t be counterfeited, debased, maximize freedom.

P: American dollar good as gold — Bretton Woods.  Silver Certificates were repudiated.